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June 26, 2013

What’s at Stake for Muni Bond Investors in Detroit Insolvency

If bondholders are bumped from the head of the creditor line, investors and insurers will have to reassess credit risk, Morningstar analyst says

A car plant in Detroit. (Photo: AP)

In what may be the most severe case of credit distress since the Great Depression, the city of Detroit is charting new territory in negotiations with creditors to avert a Chapter 9 bankruptcy filing.

What emerges from those talks that emergency manager Kevyn Orr is holding with the city’s creditors reaches far beyond whether the city will sell some of its museum’s Van Gogh masterworks or repair the 40% of its streetlights that are not functioning.

That is because Orr is proposing to treat its general obligation bonds no differently than its pension obligations despite longstanding contractual provisions that allow the government’s unlimited tax authority to back up its obligations to the former.

To assist our readers in understanding the implications for advisors and clients with municipal bond holdings in their portfolios, AdvisorOne spoke with Elizabeth Foos (left), municipal credit analyst with Morningstar and author of a new 9-page report on Detroit’s unfolding debt drama.

Tell us about the general obligation unlimited tax (GOULT) bonds that are at issue in these negotiations.

GOULT bonds are considered very strong. They have to be voter approved. They give the munipality the right and obligation to levy taxes to pay that debt service back through a dedicated unlimited revenue stream. They were assumed to be a pretty low risk and have worked fine over many decades.

Because [Detroit has] gotten quite stressed over the years, the state also pledged a direct payment of distributable state aid to several series of GOULT bonds to make them more attractive to the market and a little bit more secure.

Also, a significant part of that debt is wrapped by municipal bond insurance.

How important is debt issuance to Detroit’s day-to-day functioning?

Moving forward, the city will be hard pressed to perform efficiently without access to the [muni] market for everything from cash-flow liquidity needs to capital needs such as police vehicle stock and IT systems.

What does the emergency manager’s proposal mean for muni investors?

It highlights the need for investors to do their due diligence in credit analysis and really understand what security they own and how far down the road toward fiscal distress that issuer is.

Most likely this is going to be an opportunity for the emergency manager in a fiscally distressed situation to negotiate with creditors. The interesting part of his proposal is really the treatment of different securities as either secured or unsecured.

By calling general obligation bonds unsecured debt he puts it on par with pension liabilities and retiree health care. That begs the question of how much risk is really associated with general obligation unlimited tax debt in the state of Michigan.

If this is approved by the state, in a time of fiscal distress, the assumed strength of GOULT might not be as strong as you thought.

So the debt of other distressed Michigan cities like Flint and Pontiac may come under suspicion?

Yes. The surprise for the investor community is how the emergency manager’s proposal treats GOULTs by putting an unlimited tax pledge in the same bucket with unsecured debt—here’s $11.4 billion in unsecured debt for $2 billion in notes.

GOULT bond holders—and GOULT bonds are a common security in the State of Michigan—were probably surprised by that.

Why would Franklin Templeton or MBIA accept such an offer?

The emergency manager is proposing this restructuring plan to creditors; it’s a proposal. Better something than nothing [might be the thinking]. These are closed-door negotiations to convince a majority of creditors or else he’ll file for Chapter 9. This would be the largest city in U.S. to file for bankruptcy in history.

The municipal bond insurers have a lot at stake. What will they do?

That will be an interesting question to watch. It will force them to assess credit risk when issuing a policy. If that insurance has to be called upon it will be interesting to see how [the guarantees] are paid out and if they’re paid out.

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